Should firms be forced to adopt fair-value accounting?:
Disclose the fair value of complex securities, by Robert Kaplan, Robert Merton and Scott Richard, Commentary, Financial Times: Banks and other financial institutions are lobbying against fair-value accounting for their asset holdings. They claim many of their assets are not impaired, that they intend to hold them to maturity anyway and that recent transaction prices reflect distressed sales into an illiquid market, not what the assets are actually worth. Legislatures and regulators support these arguments, preferring to conceal depressed asset prices rather than deal with the consequences of insolvent banks.
This is not the way forward..., allowing financial institutions to ignore market transactions is a bad idea. ... Markets function best when companies disclose valid information about the values of their assets and future cash flows. If companies choose not to disclose their best estimates of the fair values of their assets, market participants will make their own judgments about future cash flows and subtract a risk premium for non-disclosure. Good accounting should reduce such dead-weight losses.
This already happens in another financial sector. Mutual funds in the US now use models, rather than the last traded price, to provide estimates of the fair values of their assets that trade in overseas markets. ... In this way, the funds ensure that their shareholders do not trade at biased net asset values calculated from stale prices. ... Obtaining fair-value estimates for complex pools of asset-backed securities, of course, is not trivial. But these days it is possible for a bank’s analysts to use recent market transaction prices as reference points and then adjust for the unique characteristics of the assets they actually hold...
Legislators and regulators fear that marking banks’ assets down to fair-value estimates will trigger automatic actions as capital ratios deteriorate. But using accounting rules to mislead regulators with inaccurate information is a poor policy. If capital calculations are based on inaccurate values of assets, the ratios are already lower than they appear. Banks should provide regulators with the best information about their assets and liabilities and, separately, allow them the flexibility and discretion to adjust capital adequacy ratios based on the economic situation. Regulators can lower capital ratios during downturns and raise them during good economic times.
No system of disclosing the fair value of complex securities is perfect. ... But reasonable and auditable methods exist today to incorporate the information in the most recent market prices. Investors, creditors, boards and regulators need not base decisions on biased values of a company’s financial assets and liabilities.
When we are experiencing an asset price bubble, we would prefer that firms value their assets at the intrinsic (true) value rather than the inflated bubble values, values that will crash when the bubble pops. However, bubbles do not always have to be positive, it's also possible for prices to deviate from intrinsic values on the low side, i.e. it's possible to have a negative bubble. In such cases, if you believe firms should use true prices rather that bubble prices when prices are above their intrinsic values, then you should also believe that the same is true when prices are below their intrinsic values. So one way to look at the question of whether current market prices are the right prices to use to value the assets on bank balance sheets is to ask whether there's reason to believe that we are in a negative bubble, i.e. if there's reason to believe that prices are artificially suppressed below their true values.
I'm not convinced that they are, but that's not a position held with much certainty, and the valuations that regulators are allowing implicitly assume that current market prices are, in fact, too low. The problem is that the true prices are not known, it's not even clear they can be estimated with any precision, and this leaves open the possibility of substantially upwardly biased valuations (the fact that we never know for sure if prices are deviating from true values is a reason to make fair-values available to those who want to use the information these valuations provide).
So there are two ways that banks balance sheets can present an overly optimistic picture. First, if the current market prices are correct, but we believe falsely that they are too low and allow firms to carry higher values on their books, then the values will be too optimistic. Second, even if the belief that current market prices are below true values, i.e. that we are in a negative bubble, is correct, it's not clear what prices we should use instead since the true price is not known. There's lots of room for firms and regulators looking to present best case scenarios to endorse overly optimistic valuations.